Crisis-tainted funds make cautious comeback

Shankar Ramakrishnan and Natalie Harrison

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NEW YORK, Oct 14 (IFR) - Enhanced cash funds are rolling out again in new forms, as investors looking for extra yield amid the money markets overhaul start to embrace an asset class with a checkered past.

With the advent of SEC money market reforms that came into effect on Friday, so-called prime funds - once the go-to place to boost returns on cash - have fallen out of favor.

And as more than US$1trn has left prime funds so far this year, short-term bond funds - essentially enhanced cash funds with a new name - are catching the eyes of investors.

The funds, often privately managed, offer potentially better yields while not being bound by the new regulations.

But they also carry many of the same risks as their predecessors, which bruised so many investors in the financial crisis - even when bearing Triple A credit ratings.

Many analysts say the lack of regulatory oversight, and the possibility of an extremely wide range of credit quality in the portfolios, should give investors pause.

CHANGE ARRIVES

The flood of money from prime funds was prompted by the new requirement that net asset values, previously kept steady at US$1, now float and are marked to market each day.

And while much of the money leaving the prime space has been flowing to government funds so far, investors are likely to find little joy in their returns.

"The hope is that government money market fund yields would increase with all this money flowing into them, but that is not going to happen," said Jerome Schneider, head of short-term portfolio management at PIMCO.

"Investors in such funds are going to be faced with anaemic yields for months and years to come."

That has opened a window for privately run funds that can hold a wide range of debt: short-term high-grade bonds, commercial paper, asset-backed paper and even Japanese bills.

Theoretically, such a portfolio could easily outperform the sovereign space where rates still remain lower for longer.

Large institutional names such as PIMCO have been offering such funds for several years - and are showing good returns.

PIMCO's enhanced short-maturity active exchange-traded fund, for example, which began in 2009, has returned 1.48% this year up to the end of August - easily outperforming Citigroup's three-month Treasury bill index, which yielded 0.16% over the same period.

"People have to recognize [the prime fund exodus] is a structural change, then pick an actively managed fund which can independently assess credit and structural risks," said Schneider.

"That is the challenge."

HIDDEN EXPENSES

But the buyside will have to avoid the mistakes that wrong-footed pre-crisis investors, who often were not fully aware of the impact of external influences on their exposures.

Many funds at the time were invested in asset-backed commercial paper, for example, and had exposure to the imploding mortgage market, triggering massive unexpected losses.

At the moment, investors appear to be treading more carefully.

Short-term corporate bond funds have seen a net inflow of US$4.41bn so far this year as of October 12, according to Lipper data.

And money has been concentrated in separate accounts managed by large funds with a capability to maintain a more globally diversified portfolio - a sign of the buyside's caution, according to Schneider.

Some money is also flowing into vehicles that mimic the characteristics of prime money funds.

Federated Investors, for example, got a Triple A rating from Fitch for a private money market fund it launched recently that intends to maintain a US$1 NAV and adhere to the liquidity, quality, maturity, diversity and disclosure guidelines of regulated money funds.

It went live on September 22 and has already attracted more than US$220m in cash, according to Crane Data.

One risk to be accounted for in short-term funds is the wider variation of maturities in them.

Analysts say prime money funds currently have a weighted average maturity around four to 20 days; for short-term funds, it could run from 40 days to as much as three years.

"Investors have to appreciate the added risk," said Sue Ann Cormack, director of sales for BNY Mellon Fixed Income.

"There is a broad range of average weighted maturities and some are higher than prime money market funds, which may add relative risk," she said.

Moreover, some investors believe that, after adjusting to the new reforms, prime funds will be able to deliver NAVs at US$1 - or close - and thus attract money back in.

"Some cash managers may prefer to remain invested in prime funds, motivated by the relative safety rather than just chasing yield," said Cormack, "especially since the crisis proved to them that investing in short-term bond funds does pose additional risk."

"It may be a good time to consider short-term funds. But investors need to understand the risk that comes with them." (Reporting by Shankar Ramakrishnan and Natalie Harrison; Editing by Marc Carnegie, Jack Doran and Matthew Davies)